Whenever I mention the term “hedge funds” to my students, the vibe of the class immediately changes. There is something magical and mysterious about what these two words represent, something sophisticated and secretive.
My students’ eyes are shining, and when I ask who they associate hedge funds with they mention Michael Burry, the legendary hedge fund manager, featured in the blockbuster movie, “The Big Short,” who made billions betting against the market during the 2008 financial crisis.
The public image of those who run hedge funds is of the smartest guys in the room. And indeed, many of them are brilliant financiers. But when it comes to performance — once fees are taken into account — the unfortunate reality is that hedge funds are lucrative mostly to the people who run them and much less so for their investors.
So, what are hedge funds and what is so unique about them?
Hedge funds raise money from high-net-worth individuals and institutional investors to create an investment pool. Then, they actively manage those funds using different strategies in an attempt to outperform the market.
As their name suggests, and in contrast to most traditional mutual funds, some hedge funds allocate a portion of their assets to buy protection, or “hedge” big risks they are exposed to.
Importantly, most hedge funds are riskier in nature than traditional funds since they employ aggressive strategies, limited diversification, and use borrowed money to enhance the returns of the fund. When investments behave according to plan, the returns are impressive; but when they don’t, things can go sour at a staggering speed.
A recent example of such a meltdown is that of Melvin Capital, once a highly successful hedge fund, which lost more than half of its value (approximately $6 billion (U.S.)) in January 2021 on a wrong bet on GameStop, WallStreetBets’ meme darling. Capital injected from other hedge funds in an attempt to save Melvin didn’t help it to recover, and it lost yet more money in 2022, which led to the announcement of the fund’s closure.
To be clear, big losses are to be expected occasionally. Investing is a risky business after all. But the most problematic feature of hedge funds lies in their infamous “2 and 20” fee structure.
The “2” means a two per cent annual management fee, independent of the fund’s results. If a hedge fund has for example, $10 billion in assets under management, the fixed annual fee would amount to $200 million.
The “20” refers to a “performance” or “incentive” fee. This means that if the fund outperformed its benchmark, it gets to keep 20 per cent of the excess return as additional compensation.
In the example above, if the fund achieved a yearly return of 15 per cent, while its benchmark appreciated by only 10 per cent, the performance fee will be equal to $100 million (20 per cent of the five per cent excess return times the fund size).
At a first glance, this doesn’t seem such a bad idea. A fund managers’ selling pitch is that the performance fee aligns them with their investors. They make money when their investors make money.
But research at the University of Arizona and The Ohio State University analyzing hedge fund returns over a 22-year period, shows that aggregately, the real performance fee is almost 50 per cent of the gains — 2.5 times the advertised 20 per cent.
“Three factors help explain the 50 per cent fee figure,” said Itzhak (Zahi) Ben-David, professor of Finance at the Fisher College of Business at Ohio State University, and a co-author of the paper. “First, the fee structure is asymmetric. Based on the contract signed with investors, fund managers earn big fees when they outperform but investors don’t get a refund when the fund underperforms. So, on average, the incentive fee as a fraction of gains, is much higher than 20 per cent.”
“Second, investors chase performance. So, when their fund isn’t performing well, they tend to switch to one that performed well recently,” Ben-David said. By doing so, the average performance fee – calculated as performance fees divided by profits – ends up being higher than 20 per cent. This is because investors paid a full 20 per cent in the good years, but eventually, when they divested their investments, their overall profit was lower, he said.
“Lastly, in many cases, poorly performing hedge funds decide to shut down. This is done since in order to be able to charge a lucrative performance fee, the fund needs to surpass the previous highest value it ever reached (a so-called ‘high-water mark’). If the fund is significantly below that threshold, closing shop and starting fresh is their best strategy. Melvin Capital did just that,” said Ben-David.
The fact that a high fee structure leads to underperformance has been proven in a famous decade-long bet launched by investor Warren Buffett back in 2007. Buffet predicted that the overall market — proxied by the performance of a low-fee index fund that tracks the S&P 500 — will outperform the net results (after fees) of any portfolio of at least five hedge funds over a 10-year period. He then publicly challenged hedge fund managers to participate in a million-dollar bet.
“I then sat back and waited expectantly for a parade of fund managers — who could include their own fund as one of the five — to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?” wrote Buffett in his 2016 letter to shareholders.
Only one hedge fund manager, Ted Seides of Protégé Partners stepped up for the challenge. Confident, Seides picked five different portfolios that invested money in more than 100 different hedge funds. But he lost the bet by a shockingly wide margin.
The hedge funds he picked had an annual average return of only 2.2 per cent. The index fund that Buffet chose, had a 7.1 per cent annual return. Buffet pointed at the fees charged by hedge funds as the main reason for their poor results.
While ordinary Canadians don’t have the money to invest in hedge funds, dozens of billions of dollars of our pension money is invested in the sector.
It is true that in many cases the strategies employed by hedge funds on behalf of our pension funds are market neutral and limited in absolute risk. But over the long-term, the inherently problematic “2 and 20” fee structure will take its toll.
CALPERS, the biggest public pension plan in the U.S., which manages more than $500 billion (U.S.) in assets, decided to terminate all investments in hedge funds back in 2014 due to unreasonable management fees. Given the evidence and the research, maybe Canada’s largest institutional investors should chart a similar path.
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